Over and over again, in budgeting articles and even books on personal finance, I see sample budgets that include debt repayment as if it were an expense. This shows a fundamental misunderstanding of what debt is. Your debt repayment is not an expense, it's an internal transfer. The only part that's an expense is the interest. The rest of the money was spent some time in the past, when you incurred the debt.

The same principle applies when you put money into your savings account. That's not "saving." The saving occured when you spent less than you earned. Putting the money into the savings account is, again, just an internal transfer.

Suppose you owe $1000 on your credit card and you have $300 in your checking account and no other savings. Your net worth is $-700. After you write a $100 check and send it to the credit card company you've got $900 in debt and $200 in your checking account. Your net worth is still $-700. The result would be the same if you opened a savings account with $100 from your checking account: Your net worth is still $-700.

This is important for two reasons:

First, you should track the interest part of the payment as a current expense. Knowing how much of your monthly income is going to interest payments gives you important information about where your money is going.

Second, it's worth thinking what the rest of the money was spent for. Today's debt payments are paying for stuff you bought in the past--maybe things you're still using, maybe things (like restaurant meals) that were used up before you even put the credit card back in your wallet. That's where your money went, not to some amorphous blob called debt repayment.

It's true that, whether it's an expense or not, you do have to come up with cash to make your credit card payments. My pointing out that (as far as your personal balance sheet goes) it's really an internal transfer, cuts no ice with the credit card companies. They'll be delighted to tack on late charges if you don't pay. So you need to have room in your budget to shift actual cash from your checking account to the credit card company. Remember, though, that (except for the interest) it's not an expense.

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I've always wondered why debt repayment is included in budgets in books because I've always figured that it shouldn't be something you should have. I mean, how can you get rich if you're starting from below zero net worth.

My own student loan difficulties are similarly a nightmare. I started with $33,000 borrowed, got into trouble, defaulted, and had a TON O' FEES added to the principal. Then in 2000 I got into the William D. Ford program, and signed up for the income contingency plan. Don't ask me why the government didn't have this option available before, back when I was patiently explaining to all the rude collectors I couldn't satisfy the minimum monthly amount, leave alone the back payments they seemed intent upon receiving. Anyway, I rehabilitated the loan, landed a fairly decent job making about $30,000, and been duly paying ever since. As I write, the payoff amount is over $200,000 and climbing. When my 25-year plan ends in 18 more years the balance to be discharged, and thereafter treated as taxable income by the IRS, may well exceed over half a million dollars.

@plonkee -- whether you get rich or not, you do it by starting where ever you are. So many people don't come to personal finance as a topic of interest until they're already in debt, that it's really necessary to cover the "getting out of debt" part of the process. I just wish they'd make it clear that "debt repayment" isn't an expense in its own right.

@Guest -- you're not going to find me supporting the sort of late fees that credit card companies charge these days. I suppose the credit card companies would claim that the fees bought you access to the credit market in the first place--if they couldn't charge those fees, they wouldn't lend to poorer credit risks at all. I think that's bogus. Probably what you bought was a new paint job for some credit card exec's Porsche.

I have seen debt-reduction advice indicating that debt should be thought of as a recurring fixed expense. I think this points to the discipline of making larger payments on debt, then snowballing as time progresses. But your distinction is right on, and consumers must know the interest on the debt and acting accordingly. One late payment on anything can cause credit card companies to jack you up to 32%. That can't get reasonably paid down.

In order to get out of credit card debt, I've traded out high interest credit cards for a 16% line of credit. Then I traded that for a tax-deductible equity loan, lowering my effective interest to about 5%. That gets paid down quicker than other debt by making larger monthly payments. It hasn't happened overnight, but debt reduction takes patience and discipline.

It seems that the budget books and financial advisers are now calling credit card debt expenses because banks and credit companies (one in the same) want people to use their credit services and keep spending and not think about paying it off, because it will only cost them "x" dollars each month which the consumer can then simply fit into their monthly budget. Since people's (generalization) monthly payment toward their debt is their real outflow of cash they equate it as the expense instead of their acquisition of products and services.

As with credit card policies, you're not going to find me supporting the policies our government has on trying to get blood from a turnip.

One thing to look into, though (and I'm no expert, so do talk to one--and in 18 years the rules will no doubt change anyway), is if you're insolvent at the time the loan is forgiven, I think the IRS doesn't treat the amount forgiven as taxable income.

I defaulted too and ended up with a ton of fees added to the principal.
I am making reduced payments but my loans are still in default.

I think the "income contingent" program didn't exist earlier because it was casually assumed that if you went to college you shouldn't have any problem repaying student loans - unless you were wildly overspending or something.

Defaulters like you and I were the pioneers who demonstrated to the student loan community and to Congress the reality of underemployed student loan borrowers and the necessity of an income contingent program.

Congress passed a student-aid bill recently which will make repayment even easier for low earners like me (and perhaps you) and I've been told that even defaulters can get into the new program. The details are to be worked out but it looks goos so far.

I understand the distinction, but what difference does it make? My debt repayment has to go into my monthly budget; it's a check that I write each month at the same time as paying my bills; if I don't pay it then I get assessed late fees - so is there something wrong with keeping it simple and calling it an expense? I expect that there are few people who are tracking their household finances with double-entry accounting like a business would.

I guess whether it makes a difference really depends on whether or not making the distinction changes the way you think about your spending. For me it did.

Seeing the interest as a current expense--as something I had to pay every month, but for which I didn't see any tangible improvement in my daily life--made me want to cut that expense.

Seeing the principle not as an expense, but as an internal transfer, helped me make decisions about allocating cash between principle repayment and investments that I was comfortable with.

Making a pie chart of where your money is going can be quite revealing and provide insight that can guide future purchasing decisions. My experience with doing that was that getting it right--showing the interest (and fees, but not principal) as a current expense--made that pie chart more more meaningful to me and more useful for guiding my decisions.

I find using a Financial Management software program has really helped me come to terms with stuff like this. Now I understand that anything I pay to my student loan debt increases my net worth. I use Gnucash (www.gnucash.org) because it's free and it does things simply and effectively. You can easily select pie or bar charts which show you where your money is going.

...And it must be that I had a year of accounting in high school, or something. But I was already viewing savings as an internal transfer--I never considered it an expense. I think I suspected for a while that something was not quite right about how I was classifying debt repayment, though, and now you have helped me straighten that out. Thank you.

Nice article. I think it is important to point out that you are looking at the issue of the credit card payment from a *Balance Sheet* point of view as opposed to a cash flow point of view. From the point of view of a balance sheet, there a difference between "payment" of principle on a debt, which is a transfer, and the accrued periodic interest, which is an expense.

However, my understanding is that from the cash flow analysis/point of view, the entire credit card payment, principal and interest included, can properly be considered an outflow and that outflow is typically categorized as "debt service", or the amount that you (or a business) has to pay out of operating cash to maintain your contractual credit obligations. In a sense then, it *is* an expense. You just have to know whether you are looking at it from a balance sheet (assets and liabilities) point of view, or a cash flow (inflow and outflow/ income and expense) point of view.

Good article. I also think it is important to point out the majority of Personal Finance Accounting is based on a Cash Basis Model, and is strictly dealing, as you point out with cash flow. While the author is technically correct, an expense is incurred and booked at the time it is purchased. It later becomes a cash flow and internal transfer at some other point in time. This is accural accounting which is a completely different beast in itself, and difficult to understand for even the best intentioned consumers. No doubt the reason most all of these personal finance budgets deal in Cash Flow/Income Expense. Most personal finance budgeting models do not follow standard accounting practices.

David Camilleri #18

Its true, from Cash Flow point of view internal transfers are 'expenses'.

Great point! It is absolutely vital for people to understand that debt repayment is not an expense. It is due to this misconception, people cringe from repaying their debt end up with accumulating even more. This article provides a great insight and reasoning why debt repayment should not be considered as an expense.

Your article is superb. However I have a question. In my Cash Flow report on Quicken, if I do not include in the report internal transfers (paying debt) then the balance of money in cash flow seems flawed. Why? Suppose my wage is $1000 cash. I spend daily living expenses for $300. Debt for $700. Remaining balance nil. If in the Cash Flow report I do not include debt as expenses, then my balance is $700 cash which in fact I did not have.
My Cash Flow Report will be flawed if I adopt your theory? Am I right? Thanks.